S&P Lawsuit Puts Ratings Firms Back In The Spotlight

In a lawsuit, the Justice Department alleges Standard and Poor's misled investors with fraudulent credit ratings. The agency could seek more than $5 billion in damages.

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Originally published on February 5, 2013 7:17 pm

The Justice Department said Tuesday it could seek more than $5 billion in damages from Standard & Poor's, the nation's biggest credit ratings company, a day after it sued the company, alleging that S&P defrauded investors by giving triple-A ratings to risky subprime mortgage investments.

The ratings business got started a century ago, when John Moody set up a company to rate railroad bonds for investors. Over the years, Moody's, S&P and Fitch, their smaller rival, expanded into other kinds of securities such as corporate and municipal bonds.

Josh Rosner of the consulting firm Graham Fisher and Co. says the ratings companies owed part of their growth to the government. He says regulators such as the Securities and Exchange Commission required anyone selling a security to first get a rating from a designated ratings company. The problem was that the SEC was particular about which companies got designated to do the ratings.

"Until you were designated as a rating agency, it would be very difficult to demonstrate that you have been a rating agency," Rosner says. "So there was this circular logic embedded in the process of approving new entrants."

As a result, the ratings business became a kind of closed shop, an oligopoly dominated by a few big players. For years, the ratings companies made money by writing up reports and selling them to investors.

Economist Lawrence White of NYU's Stern School of Business says he believes the invention of photocopying machines changed that. Suddenly, ratings companies had to worry that investors could share illegal copies of the research.

"The rating firms were afraid that the [copy] machine would do to the rating business what the Internet would do to the recorded music business three decades later — destroy the business model," White says.

So the ratings companies made a fundamental change: Instead of charging investors for their research, they began charging the companies that issued the securities they were rating. It meant that the ratings companies were dependent on big Wall Street firms for revenue.

"So a major investment bank had a much more potent threat," White says.

The threat: If you don't give me a better rating, I'm going to take my business elsewhere.

That became a big problem during the housing boom. U.S. Attorney General Eric Holder said Tuesday the ratings companies were so dependent on Wall Street money that they ignored warning signs about the mortgage meltdown.

"Put simply, this alleged conflict is egregious and it goes to the very heart of the recent financial crisis," Holder said.

In the years since the housing bust, Congress has tried to reform the ratings business. The Dodd-Frank financial reform bill seeks to encourage competition in the ratings business, but Rosner says the bill also seeks to lessen the role ratings companies play in the financial markets.

"Rating agencies do still have a business, do still have a foothold," he says. "The goal is to eat away at that over time."

Rosner says the reforms, however, don't go far enough. That hasn't been a problem so far because the market for mortgage-backed securities is still shut down. But if another housing boom occurs, he says, there's nothing to stop another flood of bad mortgage bonds from surging through the economy.

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Transcript

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Just trust us, a similar refrain was heard in the run-up to the U.S. housing collapse when Standard & Poor's gave AAA ratings to risky subprime mortgage investments. Well, late last night, the Justice Department sued the company, alleging it had defrauded investors. And today, the department said it could seek more than $5 billion in damages.

As NPR's Jim Zarroli reports, Standard & Poor's is the country's biggest ratings company. And it grew powerful in part because of federal regulations.

JIM ZARROLI, BYLINE: The ratings business got started a century ago in when John Moody set up a company to rate railroad bonds for investors. Over the years, Moody's, Standard & Poor's, and their smaller rival Fitch expanded into other kinds of securities, such as corporate and municipal bonds.

Josh Rosner, of the consulting firm Graham Fisher, says the ratings companies owed part of their growth to the government. Rosner says regulators, such as the Securities and Exchange Commission, required anyone selling a security to first get a rating from a designated ratings company. But Rosner says the SEC was very particular about which companies got designated to do the ratings.

JOSH ROSNER: Until you are designated as a rating agency, it would be very difficult to demonstrate that you've been a rating agency. So there was this circular logic embedded in the process of approving new entrants.

ZARROLI: As a result, the ratings business became a kind of closed shop, an oligopoly dominated by a few big players. For years, the ratings companies made money by writing up reports and selling them to investors. But economist Lawrence White, of NYU's Stern School of Business, believes that may have changed with the invention of the Xerox machine. Suddenly, ratings companies had to worry that investors could share illegal copies of their research.

LAWRENCE WHITE: The ratings firms were afraid that the photocopy machine would do to the rating business what the internet did to the recorded music business, three decades later - destroy the business model.

ZARROLI: So the ratings companies made a fundamental change. Instead of charging investors for their research, they began charging the companies that issued the securities they were rating. It meant that the ratings companies were dependent on big Wall Street firms for revenue.

WHITE: So a major investment bank had a much more potent threat: If you don't give me a better rating, I am going to take my business elsewhere.

ZARROLI: And that became a big problem during the housing boom. U.S. Attorney General Eric Holder says the ratings companies were so dependent on Wall Street money that they ignored warning signs about the mortgage meltdown.

ATTORNEY GENERAL ERIC HOLDER: Put simply, this alleged conduct is egregious. And it goes to the very heart of the recent financial crisis.

ZARROLI: In the years since the housing bust, Congress has tried to reform the ratings business. The Dodd-Frank Financial Reform Bill seeks to encourage competition in the industry. But Josh Rosner says the bill also seeks to lessen the role that ratings companies play in the financial market.

ROSNER: Rating agencies do still have a business; do still have a foothold. The goal is to eat away at that over time.

ZARROLI: But Rosner says the reforms don't go far enough. That hasn't been a problem so far, because the market for mortgage-backed securities is still shut down. But he says if another housing boom occurs, there's nothing to stop another flood of bad mortgage bonds from surging through the economy.

Jim Zarroli, NPR News, New York.

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This is ALL THINGS CONSIDERED from NPR News. Transcript provided by NPR, Copyright NPR.